Risk-Pooled 831(b) Captive Insurance Companies And Bad Practices Take A Beating In Avrahami

Benyamin and Orna Avahami came to the United States from Israel in 1974 and 1980 respectively. They live in Phoenix, have three children, and own three successful jewelry stores in Arizona which have about 35 employees. Their business, called American Findings Corp., elected to be taxed as an S-Corporation.

Additionally, the Avrahamis own other commercial real estate companies which own commercial properties in Arizona. More on these later. Suffice it to say now that the relevant Avrahami entities in 2006 paid about $150,000 in insurance premiums.

Desiring greater tax efficiency, the Avrahamis first talked to their CPA, Craig McEntee, who then put them on to Phoenix estate planner Neil Hiller. In turn, Hiller passed the Avrahamis on to Ms. Celia Clark, a New York lawyer who focused on tax and estate planning. Clark had also been very active with captive insurance companies since 2002, and who helped draft the captive insurance legislation for St. Kitts, a Caribbean island-nation.

This seemed to be a good fit, since the Avrahamis were already looking to forming a captive insurance company. The Avrahamis cut a check to Clark for $75,000 to form what became the Avrahamis' captive, called Feedback Insurance Company.

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Feedback was formed at the end of 2007 and obtained its insurance license from St. Kitts that year. Feedback was managed by a St. Kitts captive manager called Heritor Management, Ltd., which was itself owned by Robin Trevors. In 2008, Feedback made two tax elections with the IRS: First, because it was a foreign company, under 953(d) to be taxed as a domestic company for federal income tax purposes and, second, under 831(b) to be taxed as a small insurance company. The latter election, which was then available only to insurance companies which received less than $1.2 million in premiums, allowed Feedback to avoid paying taxes on its premium income received.

Feedback sold insurance to the Avrahami entities, and also into a terrorism risk pool (more on this later) which Clark had set up. Curiously, although the Avrahami entities were purchasing insurance from Feedback, they continue to purchase insurance as they had been from their third-party commercial insurance carriers.

To price the insurance policies which Feedback sold to the Avrahami entities, Clark hired an actuary by the name of Allen Rosenbach. Clark gave Rosenbach a variety of information, including Feedback's business plan and the insurance policies that the Avrahamis wanted Feedback to underwrite for their other businesses. Rosenbach used this information to develop a "base premium" for each policy, which then was modified using various factors.

In general, Rosenbach would find a third-party commercial insurance policy that was similar to that which Feedback issued to the Avrahami entities, and then used the pricing model charged for the commercial insurance policy to determine the base rate. First, Rosenbach modified the rate upwards because the Feedback policies were "claims made" policies, which would ostensibly cover even claims which arose before the policies were issue so long as the claim was made while the policy was in place. Second, Rosenbach modified the rate upward because Feedback's policies had no deductible. Third, Rosenbach modified the rate upward because Feedback's policies had a higher aggregate limit than the commercial policies. Fourth, Rosenbach modified the rate upwards because the scope of coverage of the Feedback policies were wider than that of the commercial insurance policies. Fifth, and finally, Rosenbach modified the rate upwards because the Feedback policies covered fines and penalties, which were not covered in the commercial policies.

If some of these modifications seem somewhat duplicative, they were, and Rosenbach would later have significant difficulty in justifying some of his modifications to the U.S. Tax Court. Applying these modifications to the "base rate" of commercial policies meant that Feedback would charge many multiples of what the Avrahamis would have paid on the street for commercially-available insurance -- for instance, Feedback charged 26.5 times ($71,000) the "base premium" ($2,675) for its employee fidelity policy.

To litigators, the term "e-mail" stands for "evidence mail" which often tells the true story of what happened in a given case. Here, the story told by e-mail was that Clark was essentially giving Rosenbach what amounted to a "target premium", and then Rosenbach would back in his numbers so that they would come out fairly close to the desired premium.

The IRS provides for two "safe harbors" for captive insurance companies attempting to meet the requirement of risk distribution (an element of "insurance" for tax law purposes). The first safe harbor is the captive underwrite at least 12 insureds and it is fine that the 12 insureds are subsidiaries of the parent company that owns the captive. This is how the vast bulk of large corporate captives meet risk distribution, since they often have dozens if not hundreds of subsidiary companies to insure.

But smaller businesses, such as the Avrahamis', don't have 12 insureds, and thus must look to the other means of providing risk distribution, which is the captive receiving at least 50% (the case law goes down as low as 30%) of its premiums from a third-party. Thus, manager of captives often will set up their own insurance companies, and sell "pooled" insurance to the operating businesses of their own clients. The manager's captive, or "pool", will then buy reinsurance from their clients' captive in about the same amount, and -- Voila! -- each captive then theoretically has taken in 50% of its premiums from a third-party source (the pool).

Which is how it worked here. The Avrahami entities in 2007 paid $360,000 to a company called Pan American Reinsurance Company, Ltd., in St. Kitts ... and the Avrahami's Feedback was paid $360,000 by Pan American for reinsurance. As Private Pyle might say, "Coincidence, coincidence!"

Pan American was owed 47.5% by Sheila Trevors, who was the wife of Robin Trevors, mentioned above as running the captive management company hired by Feedback. Another 47.5% of Pan American was owned by Laurence Mohn, who testified that he was a "courtesy director" because he had some insurance experience in the past but didn't really do anything for Pan American. The remaining 5% of Pan American was split between Diana Gentry and Carl Gentry, who were attorney Clark's children.

The Pan American risk-pooling scheme worked this way: Pan American would sell terrorism risk insurance to the operating business of Clark's clients. Concurrently, Pan American would purchase reinsurance (or cede in insurance parlance) in like amounts from the individual captives of Clark's clients. The money was held briefly in a trust account; ostensibly, to provide the risk pooling and mixing, but more realistically just for show. Clark charged clients an annual, fixed "all-inclusive" fee to participate in the program.

Although the IRS safe harbor for such "third-party risk distribution" is 50% of premiums paid to the captive, Clark thought that she could get away with only 30% of premiums paid to the captive, as this was validated in older case law involving much bigger captives. In actual dollars, this meant that the Avrahamis' jewelry stores ended up paying Pan American $360,000 for $5.25 million in terrorism insurance for the period 2009-2010, and Pan American later paid the $360,000 back over to Feedback to the "reinsurance".

Through this program, Pan American sold terrorism policies to 103 insureds for $20 million in premiums in 2009, and this money was then reinsured back into 85 captives owned by Clark's clients. The following year, 2010, Pan American sold terrorism policies to 139 insureds for $23 million, and reinsured that money back into 101 captives owned by Clark's clients. The money didn't pass all at once, but went in tranches: 50% after 90 days, 47.5% after 180 days, and then a 2.5% "loss reserve" required by Nevis was finally paid to the captives on December 15.

The terrorism risk policies issued by Pan American were similar in appearance to commercial terrorism policies, and like those policies required the certification by the U.S. Secretaries of Treasury and State, plus the Attorney General, that an act of terrorism had occurred which resulted in at least $100 million in losses in a city of less than 1.5 million residents. The Pan American policies offered somewhat broader coverage than the standard commercially-available policies, however. This was offset by some peculiar provisions, such that if Pan American suffered an event of "impaired solvency", instead of paying cash to insureds, it could issue them three-year promissory notes. Also, no individual captive which was reinsuring Pan American could be liable for the share of another captive that either could not, or would not, make up its own share.

The idea behind a risk pool is, of course, that the losses of any one insured would be made up by the larger pool. Despite his companies paying $360,000 per year for this very expensive coverage, Mr. Avrahami would later testify that he thought that Feedback's "reinsurance" liability was limited to $360,000 (i.e., $360,000 premium it received) and that he would "freak out" if Feedback lost more than the $360,000. To put this in perspective, it would be analogous to State Farm receiving a $500 premium for auto insurance, and then "freak out" if it paid more than $500 on a claim.

So how did Pan American set the pricing for its terrorism risk policies? And how did Clark's clients' captives price their reinsurance policies for that same insurance to Pan American? Re-enter actuary Rosenbach who again basically started with the commercial rates for similar policies, and then started modifying the rate steeply upwards without regard to where the company was located (a jewelry store in Phoenix would thus be priced the same as a hotel near ground zero in New York City) or the type of company being insured.

The confidence that the Avrahamis placed in the Pan American policies was amply illustrated by the fact that the Avrahamis continued to buy federally-backed terrorism policies from a third-party commercial insurance company called Jewelers Mutual. Pan American charged $360,000 per year for $5.25 million in terrorism risk cover which was not federally backed; Jewelers Mutual charged about $1,500 for $2 million in terrorism risk cover. A difference is that Pan American also covered chemical and biological hazards, whereas Jewelers Mutual did not -- always a top concern for a jewelry store in Phoenix, apparently.

So, $360,000 of the Avrahami entities' premium dollars went into Pan American for each of 2009 and 2010, and then were reinsured into Feedback. This was more than 30% of the total premiums paid by the Avrahami entities to Feedback, so that risk distribution was ostensibly met. The other 70% or less of the Avrahami entities' premiums were paid directly to Feedback for other policies, being $730,000 in 2009, and $810,000 in 2010. Thus, the Avrahami entities paid -- and deducted -- a total of $1.09 million in 2009 and $1.17 million in 2010. This was against a lost history of those two years of all policies of, well, zero; no claims were made against Feedback during those years.

Taking in big premiums, but paying out no claims, will make an insurance company like Feedback fat and happy in short order, and that is exactly the situation that transpired. But what to do with the dough? Enter Belly Button.

Belly Button was a tax partnership owned equally by the Avrahamis' three adult children, and was created in 2007. Remarkably, the Avrahamis' children, though being the record owners, had no knowledge of what it did or what it owned. In fact, Belly Button owned 27 acres of land in Snowflake, Arizona, which is about 100 miles as the crows flies northeast of Phoenix. The 27 acres were purchased for approximately $2 million, with $1.2 million in cash coming from Mr. Avrahami and the balance in a note carried by the seller.

In 2008, Feedback loaned $830,000 to Belly Button as an investment in "real estate loans", and that money was used to pay the note due to the seller and some interest due. In March of 2010, Feedback loaned another $1.5 million to Belly Button; two days after this loan, the Avrahamis (not their children) transferred $1.5 million from the Belly Button bank account to their personal one.

Later that same year, December of 2010, Feedback transferred $200,000 directly to Mrs. Avrahami, but the transaction was papered as if the money had first gone to Belly Button as a loan. Although related-party loans are usually subject to scrutiny by insurance regulators, the Feedback-to-Belly Button loans were not disclosed to the St. Kitts' regulators until 2014, which was well after the IRS started snooping around Feedback.

Speaking of the IRS, the Service sent Feedback a notice of deficiency in 2013 that challenged Feedback as a valid insurance company for tax purposes, and claimed that Feedback's premium income was simply ordinary income dressed up as insurance payments. Feedback petitioned to the U.S. Tax Court, which then set up the following opinion as to whether the moneys earned by Feedback for 2009 ($1.09 million) and 2010 ($1.17 million) were insurance premiums that were not taxable under IRC § 831(b), or were just ordinary income. It also set up whether the Avrahami entities could deduct their payments to Feedback and Pan American for like amounts. Finally, the case also set up for examination the payments to Belly Button, including the $200,000 paid by Feedback directly to Mrs. Avrahami which had been booked as if it had circulated through Belly Button. I'll get to the Opinion in a moment.

But first, some more Kabuki theatre.

In July 2013, the IRS sent the Avrahamis a document which explained their changes to the returns for the Avrahami entities, including a statement to the effect that the Avrahami entities paid Feedback some $3.9 million in premiums, but Feedback paid no claims, and that the failure to pay claims was one of the nonexclusive factors for determining that a captive insurance company was a sham. As Judge Holmes of the U.S. Tax Court was later to write:

This looks like it triggered something: By March 2013, the claims started rolling in from entities owned by the Avrahamis.

Indeed, after having gone years without paying a single claim, suddenly in 2013 the Avrahami entities suddenly started making claims, which totaled about $150,000 and included such things as $58,248 for "roof repair" and $9,800 for a "ring dispute".

It is here that we find that, despite claiming to be an insurance company, Feedback didn't actually have anything like a formal procedure for dealing with any claims that might be made. Instead, claims were resolved on an ad hoc basis, with attorney Clark herself determining whether it was covered, and then sending the claim and supporting documentation to the captive manager. The latter would then approve the claims, apparently whether they were valid or not (the IRS raised questions about claims still being paid although they were out of time under the "claims made" language of the policies).

These were the facts before Judge Holmes of the U.S. Tax Court in the case of Avrahami v. Commissioner. It is now time to see how he ruled.

Judge Holmes first noted that tax breaks for small insurance companies had been in the Internal Revenue Code since the Revenue Act of 1924. At first, only small mutual-type insurance companies were benefitted, but through the years the exemption for premium income as did the insurance companies to which it applied. By the time the Avrahamis started Feedback, section 831(b) exempted the premium income (but not the investment income) of insurance companies which earned $1.2 million or less annually. This is on the captive side; on the insured side, those paying money for what is properly "insurance" (a term defined by case law and by the Code) may deduct their payments under § 162(c) as ordinary and necessary expenses paid or incurred with a trade or business.

Insurance purchased from a true third-party is usually deductible; self-insurance usually is not. The problem is in the middle, as Judge Holmes noted:

Insurance taxation gets slightly more complicated when the insurer and the insureds are related because the line between insurance and self-insurance begins to blur.

For a captive arrangement to qualify as "insurance", the case law has evolved such that four factors must be met:

(1) Risk Shifting -- The risk is passing in a legally binding fashion from one party to the next;

(2) Risk Distribution -- The risk is distributed among other risks such that it is not a single, or predominantly single, bet against an event;

(3) Insurance Risk -- The risk is of an insurance type (loss or liability, etc.), as opposed to, say, an economic option against rising interest rates; and

(4) The Risk Meets "Commonly Accepted Notions Of Insurance" -- Basically, the risk would be considered "insurance" in the commercial insurance marketplace.